================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2001 Or [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period ___________________ to _____________________ Commission file number: 0-26456 ARCH CAPITAL GROUP LTD. (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) Bermuda Not Applicable (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 20 Horseneck Lane Greenwich, Connecticut 06830 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (203) 862-4300 -------------------------------------------------------------------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ______ ----------- Indicate the number of shares outstanding of each of the issuer's classes of common shares. <TABLE> <CAPTION> CLASS OUTSTANDING AT MARCH 31, 2001 ----- ----------------------------- <S> <C> Common Shares, $.01 par value 12,828,879 </TABLE> ================================================================================
ARCH CAPITAL GROUP LTD. INDEX <TABLE> <CAPTION> PAGE NO. ---------- PART I. FINANCIAL INFORMATION <S> <C> ITEM 1 -- CONSOLIDATED FINANCIAL STATEMENTS Review Report of Independent Accountants 1 Consolidated Balance Sheet 2 March 31, 2001 and December 31, 2000 Consolidated Statement of Income 3 For the three month periods ended March 31, 2001 and 2000 Consolidated Statement of Shareholders' Equity and 4 Comprehensive Income For the three month periods ended March 31, 2001 and 2000 Consolidated Statement of Cash Flows 5 For the three month periods ended March 31, 2001 and 2000 Notes to Consolidated Financial Statements 6 ITEM 2-- MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 16 ITEM 3-- QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 22 PART II. OTHER INFORMATION ITEM 1-- LEGAL PROCEEDINGS 23 ITEM 6-- EXHIBITS AND REPORTS ON FORM 8-K 23 </TABLE>
REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Shareholders of Arch Capital Group Ltd.: We have reviewed the accompanying consolidated balance sheet of Arch Capital Group Ltd. (formerly known as Risk Capital Holdings, Inc.) and its subsidiaries as of March 31, 2001, and the related consolidated statements of income, of changes in shareholders' equity and comprehensive income and of cash flows for each of the three-month periods ended March 31, 2001 and 2000. These financial statements are the responsibility of the Company's management. We conducted our review in accordance with standards established by the American Institute of Certified Public Accountants. A review of interim financial information consists principally of applying analytical procedures to financial data and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with generally accepted auditing standards, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion. Based on our review, we are not aware of any material modifications that should be made to the accompanying consolidated interim financial information for it to be in conformity with accounting principles generally accepted in the United States of America. We previously audited in accordance with auditing standards generally accepted in the United States of America, the consolidated balance sheet as of December 31, 2000, and the related consolidated statements of income and comprehensive income, of changes in shareholders' equity, and of cash flows for the year then ended (not presented herein), and in our report dated February 6, 2001, we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2000, is fairly stated in all material respects in relation to the consolidated balance sheet from which it has been derived. /s/ PricewaterhouseCoopers Hamilton, Bermuda May 14, 2001 1
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEET (IN THOUSANDS, EXCEPT SHARE DATA) <TABLE> <CAPTION> (UNAUDITED) MARCH 31, DECEMBER 31, 2001 2000 ----------- ----------- <S> <C> <C> ASSETS Investments: Fixed maturities (amortized cost: 2001, $90,678; 2000, $37,849) $90,400 $38,475 Publicly traded equity securities (cost: 2001, $16,859; 2000, $24,987) 28,224 51,322 Privately held securities (cost: 2001, $52,132; 2000 $60,623) 52,080 59,437 Securities held in escrow (amortized cost: 2001, $21,105; 2000, $20,887) 21,373 20,970 Short-term investments 72,421 97,387 --------- --------- Total investments 264,498 267,591 --------- --------- Cash 20,290 11,481 Accrued investment income 2,405 1,432 Premiums receivable 39,459 Unpaid losses and loss expenses recoverable 34,520 Prepaid reinsurance premiums 31,735 Reinsurance balances receivable 9,654 Goodwill 20,381 6,111 Deferred income tax asset 7,980 8,192 Deferred policy acquisition costs 2,485 Other assets 6,829 4,119 --------- --------- TOTAL ASSETS $440,236 $298,926 ========= ========= LIABILITIES Claims and claims expenses $53,413 Unearned premiums 44,133 Reinsurance balances payable 34,282 Reserve for contingent loss of escrowed assets 15,000 $15,000 Investment accounts payable 5,792 Other liabilities 15,135 8,608 --------- --------- TOTAL LIABILITIES 167,755 23,608 --------- --------- COMMITMENTS AND CONTINGENCIES SHAREHOLDERS' EQUITY Preferred shares, $.01 par value: 50,000,000 shares authorized (none issued) Common shares, $.01 par value: 200,000,000 shares authorized (issued: 2001, 12,831,860; 2000, 12,708,818) 128 127 Additional paid-in capital 289,877 288,016 Deferred compensation under share award plan (1,594) (341) Retained earnings (deficit) (22,775) (30,916) Less treasury shares, at cost (2001, 2,981) (48) Accumulated other comprehensive income consisting of unrealized appreciation of investments, net of income tax 6,893 18,432 --------- --------- TOTAL SHAREHOLDERS' EQUITY 272,481 275,318 --------- --------- Total Liabilities and Shareholders' Equity $440,236 $298,926 ========= ========= </TABLE> See Notes to Consolidated Financial Statements 2
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF INCOME (IN THOUSANDS, EXCEPT SHARE DATA) <TABLE> <CAPTION> (UNAUDITED) THREE MONTHS ENDED MARCH 31, 2001 2000 ------------ ------------- <S> <C> <C> REVENUES Net premiums written $2,837 $52,889 (Increase) decrease in unearned premiums (1,204) 5,273 ------------ ------------ Net premiums earned 1,633 58,162 Net investment income 3,160 5,290 Net investment gains 9,004 29,300 Equity in net income of investees 1,036 46 Fee income 1,715 Net commission income 482 ------------ ------------ TOTAL REVENUES 17,030 92,798 EXPENSES Claims and claims expenses 1,545 53,875 Commissions and brokerage 16,753 Other operating expenses 4,038 2,568 Foreign exchange loss 1,159 ------------ ------------ TOTAL EXPENSES 5,583 74,355 INCOME BEFORE INCOME TAXES 11,447 18,443 Federal income taxes: Current 201 264 Deferred 3,105 12,371 ------------ ------------ Income tax expense 3,306 12,635 ------------ ------------ NET INCOME $8,141 $5,808 ============ ============ AVERAGE SHARES OUTSTANDING Basic 12,786,631 15,517,163 Diluted 12,792,448 15,518,341 Basic and diluted net income per share $0.64 $0.37 </TABLE> See Notes to Consolidated Financial Statements 3
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY AND COMPREHENSIVE INCOME (IN THOUSANDS) <TABLE> <CAPTION> (UNAUDITED) THREE MONTHS ENDED, MARCH 31, 2001 2000 ------------ ------------ <S> <C> <C> COMMON SHARES Balance at beginning of year $127 $171 Common shares issued 1 ------------ ------------ Balance at end of period 128 171 ------------ ------------ ADDITIONAL PAID-IN CAPITAL Balance at beginning of year 288,016 342,034 Common shares issued 1,861 (22) ------------ ------------ Balance at end of period 289,877 342,012 ------------ ------------ DEFERRED COMPENSATION UNDER SHARE AWARD PLAN Balance at beginning of year (341) (317) Restricted common shares (issued) cancelled (1,612) 22 Compensation expense recognized 359 71 ------------ ------------ Balance at end of period (1,594) (224) ------------ ------------ RETAINED EARNINGS (DEFICIT) Balance at beginning of year (30,916) (22,175) Net income (loss) 8,141 5,808 ------------ ------------ Balance at end of period (22,775) (16,367) ------------ ------------ TREASURY SHARES, AT COST Balance at beginning of year (387) Purchase of treasury shares (48) (59,210) ------------ ------------ Balance at end of period (48) (59,597) ------------ ------------ ACCUMULATED OTHER COMPREHENSIVE INCOME UNREALIZED APPRECIATION OF INVESTMENTS, NET OF INCOME TAX Balance at beginning of year 18,432 27,188 Change in unrealized appreciation (depreciation) (11,539) (43,930) ------------ ------------ Balance at end of period 6,893 (16,742) ------------ ------------ TOTAL SHAREHOLDERS' EQUITY $272,481 $249,253 ============ ============ COMPREHENSIVE INCOME (LOSS) Net income $8,141 $5,808 Other comprehensive income, net of tax Unrealized appreciation (depreciation) of investments: Unrealized holding gains (losses) arising during period (5,387) (24,885) Less: reclassification adjustment for net realized gains included in net income (6,152) (19,045) ------------ ------------ Other comprehensive income (loss) (11,539) (43,930) ------------ ------------ Comprehensive Income (Loss) ($3,398) ($38,122) ============ ============ </TABLE> See Notes to Consolidated Financial Statements 4
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES CONSOLIDATED STATEMENT OF CASH FLOWS (IN THOUSANDS) <TABLE> <CAPTION> (UNAUDITED) THREE MONTHS ENDED, MARCH 31, 2001 2000 ------------ ------------ <S> <C> <C> OPERATING ACTIVITIES Net income $8,141 $5,808 Adjustments to reconcile net income to net cash provided by operating activities: Liability for claims and claims expenses 236 13,743 Unearned premiums 2,771 (5,274) Premiums receivable (2,478) 3,949 Accrued investment income (820) 790 Reinsurance recoverables (1,542) (6,645) Reinsurance balances payable 1,103 1,377 Deferred policy acquisition costs (241) 1,300 Net investment (gains)/losses (9,004) (29,300) Deferred income tax asset 213 12,371 Other liabilities (1,820) (3,092) Other items, net 3,747 2,279 ------------ ------------ NET CASH PROVIDED BY (USED FOR) OPERATING ACTIVITIES 306 (2,694) ------------ ------------ INVESTING ACTIVITIES Purchases of fixed maturity investments (46,708) (83,092) Sales of fixed maturity investments 13,117 136,903 Purchases of equity securities (12,119) Sales of equity securities 17,986 26,331 Net (purchases)/sales of short-term investments 23,954 (66,982) Sale or disposal (purchases) of furniture and equipment (22) 6 Acquisition of American Independent Insurance Holding Company, net of cash acquired 224 ------------ ------------ NET CASH PROVIDED BY (USED FOR) INVESTING ACTIVITIES 8,551 1,047 ------------ ------------ FINANCING ACTIVITIES Common shares issued 1,862 (22) Purchase of treasury shares (48) 3,637 Deferred compensation on restricted shares (1,612) 22 Other equity compensation (250) ------------ ------------ NET CASH PROVIDED BY (USED FOR) FINANCING ACTIVITIES (48) 3,637 ------------ ------------ Increase in cash 8,809 1,990 Cash beginning of year 11,481 9,457 ------------ ------------ CASH END OF PERIOD $20,290 $11,447 ============ ============ </TABLE> See Notes to Consolidated Financial Statement 5
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 1. ORGANIZATION Arch Capital Group Ltd. ("ACGL"), a Bermuda company, is a diversified financial services holding company, with an emphasis on the insurance sector. ACGL was formed in September 2000 to accomplish the internal reorganization transaction described below involving Arch Capital Group (U.S.) Inc. (formerly known as (i) "Risk Capital Holdings, Inc." from March 1995 to May 8, 2000 and (ii) "Arch Capital Group Ltd." from May 8, 2000 to November 8, 2000), a Delaware holding company formed in March 1995 ("Arch-U.S."). The common shares of ACGL are traded on the Nasdaq National Market under the symbol "ACGL." On November 8, 2000, following the approval of Arch-U.S.'s shareholders, Arch-U.S. completed an internal reorganization that resulted in Arch-U.S. becoming a wholly owned subsidiary of ACGL. ACGL performs the holding company functions previously conducted by Arch-U.S., and the shareholders of Arch-U.S. have become the shareholders of ACGL. Prior to the reorganization, ACGL had no significant assets or capitalization and had not engaged in any business or prior activities other than in connection with the reorganization. Arch-U.S. remains the holding company for certain United States subsidiaries. Prior to May 5, 2000, Arch-U.S. provided reinsurance and other forms of capital for insurance companies through its wholly owned subsidiary, Arch Reinsurance Company ("Arch Re"), a Nebraska corporation formed in 1995 under the original name of "Risk Capital Reinsurance Company." On May 5, 2000, Arch-U.S. sold the reinsurance operations of Arch Re to Folksamerica Reinsurance Company ("Folksamerica"). As used below, the "Company" means ACGL and its subsidiaries, except when referring to periods prior to November 8, 2000, when it means Arch-U.S. and its subsidiaries. Similarly, "Common Shares" means the common shares, par value U.S. $0.01, of ACGL, except when referring to periods prior to November 8, 2000, when it means the common stock of Arch-U.S. Class A warrants to purchase an aggregate of 2,531,079 Common Shares and Class B warrants to purchase an aggregate of 1,920,601 Common Shares were issued in connection with the direct sales of Common Shares. Class A warrants are immediately exercisable at $20 per share and expire September 19, 2002. Class B warrants are exercisable at $20 per share during the seven-year period commencing September 19, 1998, provided that the Common Shares have traded at or above $30 per share for 20 out of 30 consecutive trading days. 2. GENERAL The interim consolidated financial statements have been prepared in conformity with generally accepted accounting principles ("GAAP") in the United States and include the accounts of ACGL, Arch-U.S., Hales & Company Inc. ("Hales"), American Independent Insurance Holding Company ("AIHC"), Arch Re and Cross River Insurance Company ("Cross River"). All intercompany transactions and balances have been eliminated in consolidation. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. In the opinion of management, the accompanying interim consolidated financial statements reflect all adjustments necessary (consisting of normal recurring accruals) for a fair presentation of results on an interim basis. These consolidated financial statements should be read in conjunction with the 2000 consolidated financial statements and related notes contained in the Company's Annual Report on Form 10-K for the fiscal year ended December 31, 2000. 6
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 3. RECLASSIFICATIONS Certain amounts in the 2000 consolidated financial statements have been reclassified to conform to the 2001 presentation. Such reclassifications had no effect on the Company's net income, shareholders' equity or cash flows. 4. ACCOUNTING PRONOUNCEMENTS Statement of Financial Accounting Standard ("SFAS") No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments imbedded in other contracts, such as convertible securities, and hedging activities, and requires that all derivative financial instruments be recognized in the balance sheet as either assets or liabilities and measured at fair value. The recognition of the change in the fair value of a derivative depends on a number of factors, including the intended use of the derivative. Currently, the Company's portfolio includes market sensitive instruments, such as mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. In adopting SFAS No. 133, the recognition of the change in the fair value of any embedded derivative is recorded as a component of net income. For the Company, this statement was effective for the year beginning January 1, 2001, and has been adopted herein. SFAS No. 133 did not have a material impact on the Company's results of operations, financial condition or liquidity because the Company generally does not engage in derivative activities. 5. GOODWILL Goodwill of acquired businesses represents the difference between purchase cost and the fair value of the net assets of the acquired businesses and is being amortized on a straight-line basis over the expected life of the related operations acquired, which generally does not exceed 15 years. The Company recorded goodwill related to its investment in Hales and AIHC. The Company evaluates the recoverability of the carrying value of goodwill related to acquired businesses on an undiscounted basis to ensure it is properly valued. If it is determined that an impairment exists, the excess of the unamortized balance will be charged to earnings at that time. 6. CONTINGENCIES RELATING TO SALE OF REINSURANCE OPERATIONS Under the terms of the agreement relating to the sale of the Company's reinsurance operations to Folksamerica on May 5, 2000, the Company placed $20 million of the purchase price in escrow for a period of five years. Such amounts represent restricted funds that appear under a separate caption entitled "Securities held in escrow" on the Company's consolidated balance sheet at March 31, 2001. These funds will be used to reimburse Folksamerica if the loss reserves (which were $32.3 million at the closing of the asset sale) transferred to it in the asset sale relating to business produced on behalf of Arch Re by a certain managing underwriting agency are deficient as measured at the end of such five-year period or to satisfy certain indemnity claims Folksamerica may have during such period. In connection with the escrow arrangement, the Company will record a loss in an amount equal to any probable deficiency in the related reserve that may become known during or at the end of the five-year period. If such loss reserves are redundant, all of the escrowed funds will be released from escrow to the Company and Folksamerica will pay the Company an amount equal to such redundancy. As required under the agreement, Folksamerica reported to the Company that adverse development had occurred in the loss reserves subject to the Folksamerica escrow agreement for the period from May 5, 2000 to December 31, 2000. Based on such information and an independent actuarial analysis, the Company recorded 7
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 6. CONTINGENCIES RELATING TO SALE OF REINSURANCE OPERATIONS (CONT'D.) in the 2000 fourth quarter a loss contingency of $15 million, on a pre-tax basis, to recognize a probable deficiency in such reserves. The actuarial analysis was based on estimates of claims and claims expenses incurred as of December 31, 2000 and, therefore, the amount ultimately paid may be more or less than such estimate. Under the terms of the agreement, the Company has also purchased reinsurance protection covering the Company's aviation business to reduce the net financial loss to Folksamerica on any large commercial airline catastrophe to $5.4 million, net of reinstatement premiums. Although the Company believes that any such net financial loss will not exceed $5.4 million, the Company has agreed to reimburse Folksamerica for a net financial loss it may incur that is in excess of $5.4 million for aviation losses under certain circumstances prior to May 5, 2003. The Company also made representations and warranties to Folksamerica about the Company and the business transferred to Folksamerica for which the Company retains exposure for certain periods. Although Folksamerica has not asserted that any amount is currently due under any of the indemnities provided by the Company under the asset purchase agreement, Folksamerica has indicated a potential indemnity claim under the agreement in the event of the occurrence of certain future events. Based on all available information, the Company denies the validity of any such potential claim. At the closing of the asset sale, Arch Re and Folksamerica entered into a transfer and assumption agreement, under which Folksamerica assumed Arch Re's rights and obligations under the reinsurance agreements transferred in the asset sale. The reinsureds under such agreements that were in-force were notified that Folksamerica had assumed Arch Re's obligations and that, unless the reinsureds object to the assumption, Arch Re will be released from its obligations to those reinsureds. None of such reinsureds objected to the assumption and, accordingly, the gross liabilities for such business have been removed from the accounts of Arch Re for statutory and GAAP accounting purposes. However, Arch Re will continue to be liable under those reinsurance agreements if the notice is found not to be an effective release by the reinsureds. Folksamerica has agreed to indemnify the Company for any losses arising out of the reinsurance agreements transferred to Folksamerica Reinsurance Company in the asset sale. However, in the event that Folksamerica refuses or is unable to perform its obligations to the Company, Arch Re may incur losses relating to the reinsurance agreements transferred in the asset sale. 7. ACQUISITION On February 28, 2001, the Company completed a reorganization transaction pursuant to which the Company acquired all of the common stock of AIHC, one of its investee companies. See Note 9. AIHC is a specialty property and casualty insurance holding company that, through its subsidiaries, markets and underwrites nonstandard personal automobile liability and physical damage lines of insurance, primarily in Pennsylvania, as well as in Maryland and Delaware. The Company purchased a portion of the outstanding shares of AIHC for $1.25 million. The remaining outstanding shares of AIHC were redeemed by AIHC in exchange for the right to receive a portion of the proceeds resulting from the final adjudication or settlement of certain lawsuits that AIHC, as plaintiff, has previously filed against certain defendants. A third party also forgave the obligations owing to it under certain notes previously issued by AIHC in the aggregate principal amount of $4 million and returned certain warrants 8
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 7. ACQUISITION (CONT'D.) to purchase shares of AIHC in exchange for the right to receive a portion of the proceeds resulting from the final adjudication or settlement of such lawsuits. Immediately after the Company's purchase of AIHC, the Company contributed to the capital of AIHC notes in the aggregate principal amount of $8.5 million that were issued to the Company in connection with loans it had previously made to AIHC and also returned certain warrants to purchase shares of AIHC. Following the purchase, the Company also made a capital contribution to AIHC in the amount of $11 million. In connection with the loans the Company had previously made to AIHC, the Company had obtained rights to provide reinsurance to AIHC's subsidiary, American Independent Insurance Company ("American Independent"), for specified periods, which rights had been transferred to Folksamerica in the asset sale on May 5, 2000. In connection with the Company's acquisition of AIHC, Folksamerica released American Independent from these reinsurance commitments at a cost to American Independent of $1.5 million. 8. EARNINGS PER SHARE DATA Earnings per share are computed in accordance with SFAS No. 128 "Earnings Per Share." Basic earnings per share exclude dilution and is computed by dividing income available to common shareholders by the weighted average number of Common Shares outstanding for the periods. Diluted earnings per share reflect the potential dilution that could occur if Class A and B warrants and employee stock options were exercised or converted into Common Shares. When a loss occurs, diluted per share amounts are computed using basic average shares outstanding because including dilutive securities would decrease the loss per share and would therefore be anti-dilutive. The following table sets forth the computation of basic and diluted earnings per share: <TABLE> <CAPTION> (IN THOUSANDS, EXCEPT SHARE DATA) THREE MONTHS ENDED MARCH 31, 2001 2000 ---------------- --------------- <S> <C> <C> NET INCOME BASIC EARNINGS PER SHARE: Net income $8,141 $5,808 Divided by: Weighted average shares outstanding for the period 12,786,631 15,517,163 Basic earnings per share $0.64 $0.37 DILUTED EARNINGS PER SHARE: Net income $8,141 $5,808 Divided by: Weighted average shares outstanding for the period 12,786,631 15,517,163 Effect of dilutive securities: Warrants Employee stock options 5,817 1,178 ---------------- --------------- Total shares 12,792,448 15,518,341 ================ =============== Diluted earnings per share $0.64 $0.37 </TABLE> 9
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. INVESTMENT INFORMATION Realized investment gains (losses) for the three month period ended March 31, 2001 consisted of the following: <TABLE> <CAPTION> (IN THOUSANDS) THREE MONTHS ENDED MARCH 31, 2001 --------------------------------- NET GROSS GROSS REALIZED REALIZED REALIZED GAINS GAINS LOSSES (LOSSES) ---------- --------- --------- <S> <C> <C> <C> Fixed maturities $53 $53 Publicly traded equity securities 8,951 8,951 Privately held securities ---------- --------- --------- Total $9,004 $9,004 ========== ========= ========= </TABLE> The following table reconciles estimated fair value and carrying value to the amortized cost of fixed maturities and equity securities: <TABLE> <CAPTION> (IN THOUSANDS) MARCH 31, 2001 ------------------------------------------------------- ESTIMATED FAIR VALUE AND GROSS GROSS CARRYING UNREALIZED UNREALIZED AMORTIZED VALUE GAINS (LOSSES) COST ---------- ---------- ---------- --------- <S> <C> <C> <C> <C> Fixed maturities $90,400 $1,666 ($1,944) $90,678 Publicly traded equity securities 28,224 12,213 (848) 16,859 Privately held securities 52,080 (52) 52,132 Securities held in escrow 21,373 268 21,105 ---------- ---------- ---------- --------- Total $192,077 $14,147 ($2,844) 180,774 ========== ========== ========== ========== </TABLE> The Company classifies all of its publicly traded fixed maturities and equity securities as "available for sale" and, accordingly, they are carried at estimated fair value. The fair value of publicly traded fixed maturities and publicly traded equity securities is estimated using quoted market prices or dealer quotes. Short-term investments, which have a maturity of one year or less at the date of acquisition, are carried at cost, which approximates fair value. 10
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. INVESTMENT INFORMATION (CONT'D.) At March 31, 2001, the Company's publicly traded equity securities and privately held securities were issued by insurance and reinsurance companies or companies providing services to the insurance industry. At such date, the publicly traded equity portfolio consisted of the following: <TABLE> <CAPTION> (IN THOUSANDS) MARCH 31, 2001 ------------------------------------------------------------ ESTIMATED FAIR VALUE AND GROSS GROSS CARRYING UNREALIZED UNREALIZED VALUE GAINS (LOSSES) COST ----------- ----------- ---------- ----------- <S> <C> <C> <C> <C> COMMON STOCK: ACE Limited $9,224 $2,908 $6,316 XL Capital Ltd 7,987 4,403 3,584 Farm Family Holdings, Inc. 1,342 430 912 Meadowbrook Insurance Group 610 ($848) 1,458 Renaissance Re 2,450 1,253 1,197 Metropolitan Life Insurance Company 6,611 3,219 3,392 ----------- ----------- ---------- ----------- Total $28,224 $12,213 ($848) $16,859 =========== =========== ========== =========== </TABLE> Investments in privately held securities may include both equity securities and securities convertible into, or exercisable for, equity securities (some of which may have fixed maturities). Privately held securities are subject to trading restrictions or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in the Company's inability to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security which the Company seeks to sell. Such investments are classified as "available for sale" and carried at estimated fair value, except for investments in which the Company believes it has the ability to exercise significant influence (generally defined as investments in which the Company owns 20% or more of the outstanding voting common stock of the issuer), which are carried under the equity method of accounting. Under this method, the Company records its proportionate share of income or loss for such investments in results of operations. Goodwill for privately held equity securities carried under the equity method of accounting was $7.9 million at March 31, 2001, compared to $8.0 million at December 31, 2000. The estimated fair value of investments in privately held securities, other than those carried under the equity method or those with quoted market values, is initially equal to the cost of such investments until the investments are revalued based principally on substantive events or other factors which could indicate a diminution or appreciation in value, such as an arm's-length third party transaction justifying an increased valuation or adverse development of a significant nature requiring a write-down. The Company periodically reviews the valuation of investments in privately held securities with MMC Capital, Inc. ("MMC Capital"), its equity investment advisor with respect to certain of the Company's privately held securities. 11
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. INVESTMENT INFORMATION (CONT'D.) Privately held securities consisted of the following: <TABLE> <CAPTION> (IN THOUSANDS) MARCH 31, DECEMBER 31, 2001 2000 -------------- ------------- <S> <C> <C> CARRIED UNDER THE EQUITY METHOD: The ARC Group, LLC $8,039 $8,468 Arx Holding Corp. 3,458 3,514 Island Heritage Insurance Company, Ltd. 4,575 4,534 New Europe Insurance Ventures 705 642 Sunshine State Holding Corporation 2,140 1,766 -------------- ------------- Sub-total 18,917 18,924 -------------- ------------- CARRIED AT FAIR VALUE: Altus Holdings, Ltd. 16,000 16,000 American Independent Insurance Holding Company 7,350 Distribution Investors, LLC 100 100 GuideStar Health Systems, Inc. 250 250 Stockton Holdings Limited 10,000 10,000 Trident II, L.P. 6,813 6,813 -------------- ------------- Sub-total 33,163 40,513 -------------- ------------- Total $52,080 $59,437 ============== ============= </TABLE> During the three-month period ended March 31, 2001, the Company received distributions from The ARC Group, LLC totaling $945,000. At March 31, 2001, the Company had investment commitments relating to its privately held securities totaling approximately $22 million. The outstanding commitments at March 31, 2001 included $17.6 million committed to Trident II, L.P., an investment fund established by MMC Capital dedicated to making private equity and equity related investments in the global insurance, reinsurance and related industries, and $1.2 million to Distribution Investors, LLC, the general partner of Distribution Partners Investment Capital, L.P., a private equity fund investing in insurance distribution entities which is affiliated with Hales. Set forth below is certain information relating to the Company's private investment activity for the three month period ended March 31, 2001: AMERICAN INDEPENDENT INSURANCE HOLDING COMPANY On February 28, 2001, the Company completed a reorganization transaction pursuant to which the Company acquired all of the common stock of one of its investee companies, AIHC. See Note 7. Immediately after the Company's purchase of AIHC, the Company contributed to the capital of AIHC notes in the aggregate principal amount of $8.5 million that were issued to the Company in connection with loans it had previously made to AIHC. At that date, the Company restored the estimated market value discount on the loans in the amount of $1.1 million, which had been previously recorded in the Company's financial statements. The Company also returned certain warrants to purchase shares of AIHC. 12
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 9. INVESTMENT INFORMATION (CONT'D.) ALTUS HOLDINGS, LTD. On March 23, 2001, the Company entered into a reorganization agreement for the acquisition of all of the remaining ownership interests in one of its current investee companies, Altus Holdings, Ltd. ("Altus"), which provides insurance and alternative risk transfer services through rent-a-captive and other facilities. The Altus group includes First American Insurance Company, an admitted insurer with licenses in 49 states and an A.M. Best rating of A-. Under the agreement, the Company will acquire Altus for a purchase price of approximately $36 million. The transaction is contingent on obtaining applicable regulatory approvals, expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act, and other customary closing conditions. 10. INCOME TAXES ACGL is incorporated under the laws of Bermuda and, under current Bermuda law, is not obligated to pay any taxes in Bermuda based upon income or capital gains. The Company has received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to ACGL or any of its operations until March 28, 2016. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda. ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the U.S. and is not exempt from U.S. tax under an applicable income tax treaty with the United States. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors. ACGL's U.S. subsidiaries will continue to be subject to U.S. income taxes on their worldwide income. Arch-U.S., Hales, Arch Re and Cross River file a U.S. consolidated federal income tax return, with Arch-U.S. serving as the common parent, and have a tax sharing agreement (the "Tax Sharing Agreement"), allocating the consolidated income tax liability on a separate return basis. Pursuant to the Tax Sharing Agreement, Hales, Arch Re and Cross River make tax sharing payments to Arch-U.S. based on such allocation. In addition, AIHC, a U.S. subsidiary of ACGL, files a separate U.S. consolidated return with its subsidiaries, American Independent, American Independent Services Company and C&L Insurance Agency, Inc. 13
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 10. INCOME TAXES (CONT'D.) An analysis of the Company's effective tax rate for the three months ended March 31, 2001 and 2000 follows: <TABLE> <CAPTION> (IN THOUSANDS) THREE MONTHS ENDED MARCH 31, 2001 2000 ------------ ------------ <S> <C> <C> Income tax computed on pre-tax income $4,007 $ 6,455 Addition (reduction) in income tax resulting from: Valuation allowance (174) 6,285 Write-off of deferred tax asset 251 Tax-exempt investment income (162) Dividend received deduction (15) (127) Foreign income, not subject to income tax (839) Other 76 184 ------------ ------------ Income tax expense on pre-tax income $3,306 $12,635 ============ ============ </TABLE> Deferred income taxes reflect the tax effect of temporary differences between the value of assets and liabilities for financial reporting purposes and such values as measured by U.S. tax laws and regulations. The net deferred income tax asset is net of a valuation allowance for the portion of the deferred tax asset that management believes may not be realized. Significant components of the Company's deferred income tax assets and liabilities as of March 31, 2001 and December 31, 2000 were as follows: <TABLE> <CAPTION> (IN THOUSANDS) MARCH 31, DECEMBER 31, 2001 2000 ------------- ------------- <S> <C> <C> Deferred income tax assets: Net operating loss $12,900 $12,465 AMT credit carryforward 651 651 Net claim reserve discount 856 Net unearned premium reserve 868 Unrealized loss on private equity 262 262 Unrealized loss on marketable securities 548 606 Compensation liabilities 53 250 Net unrealized depreciation of investments 262 Other, net 805 48 ------------- ------------- Total deferred tax assets 17,205 14,282 ------------- ------------- Deferred income tax liabilities: Equity in net income on investees, net (549) (379) Deferred policy acquisition cost (869) Net unrealized appreciation of investments (61) ------------- ------------- Total deferred tax liabilities (1,418) (440) ------------- ------------- Valuation allowance (7,807) (5,650) ------------- ------------- Net deferred income tax asset $7,980 $8,192 ============= ============= </TABLE> As of March 31, 2001, the Company has a deferred income tax valuation allowance of $7.8 million that adjusts the net deferred income tax asset to its estimated realizable value of approximately $8.0 million. The Company's U.S. subsidiaries have total net operating loss carryforwards of $36.9 million, substantially all of which expire between 2019 and 2020. 14
ARCH CAPITAL GROUP LTD. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 11. SEGMENT INFORMATION The Company is a Bermuda-based, diversified financial services holding company, with an emphasis on the insurance sector. The Company owns and intends to acquire operating businesses that will enable it to generate both fee-based revenue (E.G., commissions and advisory and management fees) and risk-based revenue (I.E., insurance premium). SFAS No. 131 requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. As described below, the Company's two operating segments include insurance and merchant banking: <TABLE> <CAPTION> BUSINESS IDENTITY BUSINESS ACTIVITY - ------------------------------------------- --------------------------------------- <S> <C> American Independent Insurance Holding Markets and underwrites nonstandard Company personal automobile liability and physical damage lines of insurance, primarily in Pennsylvania. Hales & Company Inc. A merchant banking firm specializing in the insurance industry. </TABLE> The Company's insurance operating segment includes total assets of $160.8 million at March 31, 2001, and revenues of $3 million and net income of $117,000 for the quarter ended March 31, 2001. The results of the Company's merchant banking operating segment did not meet any of the thresholds for segment reporting. Its contribution to the Company's net income was not material for the 2001 first quarter. 15
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS. GENERAL THE COMPANY Arch Capital Group Ltd. ("ACGL") is a Bermuda-based, diversified financial services holding company, with an emphasis on the insurance sector. We own and intend to acquire operating businesses that will enable us to generate both fee-based revenue (E.G., commissions and advisory and management fees) and risk-based revenue (I.E., insurance premium). We will participate in the insurance sector through our ownership interest in various insurance-related entities such as intermediaries, underwriting agencies, service providers and insurance companies, each of which will capture a portion of insurance premium at different points in the insurance chain. As part of our strategy of diversification and of growing our sources of fee-based revenues, we may also acquire ownership interests in financial services entities outside the insurance sector. In connection with the development of the risk bearing portion of our business, we intend to capitalize a Bermuda-based reinsurance company, which will underwrite business produced by intermediaries, underwriting agencies and insurance companies owned by or affiliated with us, as well as business produced by third parties. The Bermuda location provides us with a favorable business environment for engaging in some of our risk-based activities. We believe that our ownership interests in a Bermuda-based reinsurance company and other risk-bearing entities, as well as in insurance intermediaries, underwriting agencies and other fee-based businesses, will enable us to maximize risk-based revenues during periods in the underwriting cycle when it is favorable to assume more underwriting risk, and to increase our focus on fee-based revenues and assume less underwriting risk when the underwriting cycle presents less favorable conditions. In November 2000, ACGL became the sole shareholder of Arch Capital Group (U.S.) Inc. ("Arch-U.S.") pursuant to an internal reorganization transaction. Arch-U.S. is a Delaware company formed in March 1995 under the original name of "Risk Capital Holdings." Arch-U.S. commenced operations in September 1995 following the completion of its initial public offering. Prior to May 5, 2000, Arch-U.S. provided reinsurance and other forms of capital for insurance companies through its wholly owned subsidiary, Arch Reinsurance Company ("Arch Re"), a Nebraska corporation formed in 1995 under the original name of "Risk Capital Reinsurance Company." On May 5, 2000, Arch-U.S. sold the reinsurance operations of Arch Re to Folksamerica Reinsurance Company in an asset sale. On February 28, 2001, we completed a reorganization transaction pursuant to which we acquired all of the common stock of American Independent Insurance Holding Company ("AIHC"), one of our investee companies. AIHC, through its wholly owned subsidiary, American Independent Insurance Company, markets and underwrites nonstandard personal automobile liability and physical damage lines of insurance, primarily in Pennsylvania, as well as in Maryland and Delaware. On an ongoing basis we will determine the amount of the insurance premium produced by American Independent that will be retained by us and the amount of commission income we will capture through the purchase of reinsurance. For the year 2001, we will reinsure with third parties approximately 70% of American Independent's business and retain the remaining underwriting risk. See note 7 under the caption "Acquisition" of the notes accompanying our consolidated financial statements. COMPANY INFORMATION At March 31, 2001, our consolidated shareholders' equity was $272.5 million. Our common shares are traded on the Nasdaq National Market under the symbol "ACGL." Our principal offices are located at Clarendon House, 2 Church Street, Hamilton HM 11 Bermuda (phone number: (441) 295-1422), and our executive offices are located at 20 Horseneck Lane, Greenwich, Connecticut 06830 (phone number: (203) 862-4300). 16
LIQUIDITY AND CAPITAL RESOURCES We are a holding company whose assets primarily consist of the stock of our subsidiaries and invested assets totaling $194.3 million at March 31, 2001. We continuously investigate possible acquisitions of new businesses in support of our strategy and evaluate the retention or disposition of our existing subsidiaries and investments. Accordingly, while we do not currently have any material arrangements or commitments with respect thereto (except as disclosed in this report), we intend to make further acquisitions, and it is possible that divestitures and changes in capital structure could occur. We depend on our available cash resources, liquid investments and dividends or other distributions from our subsidiaries to make payments, including the payment of operating expenses we may incur and for any dividends our board of directors may determine. Our board does not currently intend to declare any dividends or make any other distributions. As of March 31, 2001, we had $45.2 million of cash and short-term investments, $62.6 million of fixed maturity investments, and $27.6 million of publicly traded equity securities. As of that date, investments that are restricted or generally unavailable for liquidity purposes included $37.5 million of privately held securities and $21.4 million of fixed maturity investments held in escrow in connection with the sale of our reinsurance operations. In addition, we have an investment commitment relating to our privately held investment in Trident II totaling approximately $17.6 million. Amounts discussed above do not include the stock of our subsidiaries or their invested assets. See note 9 under the caption "Investments" of the notes accompanying our consolidated financial statements. Our future net cash flow will depend on the receipt of dividends and other distributions from our subsidiaries and proceeds on the disposition of such subsidiaries, as well as investment income and proceeds on the sale or maturity of our investments. The ability of our insurance subsidiaries, American Independent and Arch Re, to pay dividends or make distributions is dependent on their ability to meet applicable regulatory standards. Based on 2000 results, American Independent may not pay any dividends or make other distributions during 2001 without prior regulatory approval. Due to the distributions made by Arch Re in connection with the XL Capital share repurchase and our redomestication to Bermuda in 2000, Arch Re may not make any distributions without prior regulatory approval until December 2001. We expect that our operational needs for the foreseeable future will be met by our balance of cash and short-term investments, as well as by funds generated from investment income and proceeds on the sale or maturity of our investments. We will continue to pursue and investigate possible business combinations and ventures with new operating businesses in furtherance of our strategy. In that connection, we may need to secure additional financing to carry out our business plan. We cannot assure you that we will be successful in obtaining any such financing or in the implementation of our business plan. Consolidated cash flows from operating activities for the three months ended March 31, 2001 and 2000 was approximately $0.3 million and ($2.7) million, respectively. We are subject to certain contingencies relating to the sale of our reinsurance operations on May 5, 2000, as described in note 6 under the caption "Contingencies Relating to the Sale of Reinsurance Operations" of the notes accompanying our consolidated financial statements. ACQUISITION On March 23, 2001, we entered into a reorganization agreement for the acquisition of all of the remaining ownership interests in Altus Holdings, Ltd., which provides insurance and alternative risk transfer services through rent-a-captive and other facilities. The Altus group includes First American Insurance Company, an admitted insurer in 49 states with an A.M. Best rating of "A-." Under the agreement, we will acquire the remaining ownership interests in Altus for a purchase price of approximately $36 million. The transaction, which is currently expected to close during the 2001 second quarter, is contingent on obtaining applicable regulatory approvals, expiration of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act, and other customary closing conditions. Upon the closing of the acquisition, through Altus and First American, we will be able to assist a producer, manager or distributor of insurance premium seeking to participate in the underwriting results of its 17
business or requiring a licensed carrier. We will also be able to provide services to businesses that are seeking to insure a portion of their corporate risk exposures with a captive insurance company. INVESTMENTS We seek to acquire operating companies in support of our business plan of building a diversified financial services holding company. Our success depends to a large extent on the operations, financial condition and management of the companies with which we may merge or which we may acquire in whole or in part. At March 31, 2001, consolidated cash and invested assets totaled approximately $284.8 million, consisting of $92.7 million of cash and short-term investments, $90.4 million of publicly traded fixed maturity investments, $21.4 million of fixed maturities held in escrow, $28.2 million of publicly traded equity securities, and $52.1 million of privately held securities. Our publicly traded equity portfolio consists of securities issued by insurance and reinsurance companies and companies providing services to the insurance industry. Such portfolio lacks industry diversification and will be particularly subject to the performance of the insurance industry. Unlike fixed income securities, equity securities such as common stocks, including the equity securities in which we have invested, generally are not and will not be rated by any nationally recognized rating service. The values of equity securities generally are more dependent on the financial condition of the issuer and less dependent on fluctuations in interest rates than are the values of fixed income securities. The market value of equity securities generally is regarded as more volatile than the market value of fixed income securities. Since the realization of gains and losses on equity investments is not generally predictable, such gains and losses have differed and will differ significantly from period to period. Variability and declines in our results of operations could be further exacerbated by certain private equity investments which are accounted for under the equity method. The effects of such volatility on our equity portfolio could be worsened to the extent that such portfolio is concentrated in the insurance industry and in relatively few issuers. Investments included in our private portfolio include securities issued by privately held companies that are generally restricted as to resale or are otherwise illiquid and do not have readily ascertainable market values. The risk of investing in such securities is generally greater than the risk of investing in securities of widely held, publicly traded companies. Lack of a secondary market and resale restrictions may result in an inability by us to sell a security at a price that would otherwise be obtainable if such restrictions did not exist and may substantially delay the sale of a security we seek to sell. At March 31, 2001, our private equity portfolio consisted of ten investments, with additional investment portfolio commitments in an aggregate amount of approximately $22.0 million. See note 9 under the caption "Investment Information" of the notes accompanying our consolidated financial statements for certain information regarding our publicly traded and privately held securities and their carrying values, and commitments made by us relating to our privately held securities. On February 28, 2001, we completed a reorganization transaction pursuant to which we acquired all of the common stock of AIHC, one of our investee companies. On March 23, 2001, we entered into a reorganization agreement for the acquisition of the remaining ownership interests in Altus Holdings, Ltd., another of our investee companies. See "--Acquisition" above and note 7 and note 9 of the notes accompanying our consolidated financial statements. At March 31, 2001, approximately 86.9% of our fixed maturity and short-term investments were rated investment grade by Moody's or Standard & Poor's and had an average quality rating of A+ and an average duration of approximately 1.5 years. In November 2000, we liquidated our high yield portfolio in connection with our reorganization transaction. In January 2001, we began to reinvest approximately $35 million of cash in high yield fixed maturity investments. At March 31, 2001, we had approximately $33.6 million of such funds invested in high yield investments, with an average quality rating of BB- and an average duration of 4.6 years. During the 2001 first quarter, we liquidated a substantial portion of the public equity portfolio. The proceeds from the sales, which amounted to $18 million, were reinvested in short-term money market securities. 18
We have not invested in derivative financial instruments such as futures, forward contracts, swaps, or options or other financial instruments with similar characteristics such as interest rate caps or floors and fixed-rate loan commitments. Our portfolio includes market sensitive instruments, such as mortgage-backed securities, which are subject to prepayment risk and changes in market value in connection with changes in interest rates. MARKET SENSITIVE INSTRUMENTS AND RISK MANAGEMENT In accordance with the SEC's Financial Reporting Release No. 48, we performed a sensitivity analysis to determine the effects that market risk exposures could have on the future earnings, fair values or cash flows of our financial instruments as of December 31, 2000. (See "Management's Discussion and Analysis of Financial Condition and Results of Operations" included in our 2000 Annual Report on Form 10-K.) Market risk represents the risk of changes in the fair value of a financial instrument and is comprised of several components, including liquidity, basis and price risks. At March 31, 2001, there have been no material changes in market risk exposures that affect the quantitative and qualitative disclosures presented as of December 31, 2000. RESULTS OF OPERATIONS NET INCOME For the 2001 first quarter, we reported net income of $8.1 million, or $0.64 per share, compared with net income of $5.8 million, or $0.37 per share, for the 2000 first quarter. The 2001 first quarter net income included after-tax net realized investment gains of $6.2 million, or $0.48 per share, and after-tax equity in net income of investees of $688,000, or $0.05 per share. These amounts compare with after-tax net realized investment gains of $19 million, or $1.23 per share, and after-tax equity in net income of investees of $30,000, for the 2000 first quarter. SEGMENT DATA Statement of Financial Accounting Standard No. 131 requires certain disclosures about operating segments in a manner that is consistent with how management evaluates the performance of the segment. Our two operating segments include insurance and merchant banking. See note 11 under the caption "Segment Information" of the notes accompanying our consolidated financial statements. On February 28, 2001, we completed our acquisition of AIHC, a specialty property and casualty insurance holding company that, through its subsidiaries, markets and underwrites nonstandard personal automobile liability and physical damage lines of insurance, primarily in Pennsylvania, as well as in Maryland and Delaware. AIHC's net income for the one-month period was not material to our first quarter results. See note 7 and note 9 of the notes accompanying our consolidated financial statements. Revenues from our merchant bank, Hales, could vary significantly from quarter to quarter. Such revenues are dependent upon (i) deal flow, which is influenced by various factors, including the insurance marketplace and economic conditions, and (ii) risks associated with closing transactions, which include regulatory and other approvals and other factors outside the control of Hales. Hale's results of operations for the three months ended March 31, 2001 were not material to our first quarter results. BOOK VALUE PER SHARE At March 31, 2001, consolidated shareholders' equity totaled $272.5 million, or $21.24 per share, compared with $275.3 million, or $21.66 per share, at December 31, 2000. The decrease in book value resulted from a decline in unrealized appreciation of our investment portfolio totaling $11.5 million, or $0.90 per share, partially offset by net income. On a diluted basis, which included dilutive options outstanding, book value per share was $21.05 at March 31, 2001, compared with $21.66 at December 31, 2000. 19
NET INVESTMENT INCOME After-tax net investment income for the 2001 first quarter was $2.9 million, compared with $3.7 million for the 2000 first quarter. The decrease in net investment income in 2001 compared with 2000 primarily reflected the decline in our average invested asset base resulting from the sale of Arch Re's reinsurance operations in May 2000, partially offset by a decrease in investment expenses and higher overall investment yields. Our yields have moderately increased as proceeds from the sales of public equity securities have been allocated into short-term investments over the last several quarterly periods. For the three month periods ended March 31, 2001 and 2000, our sources of net realized investment gain (losses) were as follows (in thousands): <TABLE> <CAPTION> THREE MONTHS ENDED MARCH 31, ------------------------------- 2001 2000 ------------------------------- <S> <C> <C> Fixed maturities $ 53 ($ 2,399) Publicly traded equity securities 8,951 35,359 Privately held securities (3,660) -------------- --------------- Total $9,004 $29,300 ============== =============== </TABLE> During the three months ended March 31, 2001, we disposed of, or reduced our position in, several publicly traded equity security investments, producing a net realized gain of $9.0 million. For the first three months of 2001, the change in after-tax net unrealized appreciation of investments of $11.5 million reflects the following (in millions): <TABLE> <CAPTION> MARCH 31, DECEMBER 31, 2001 2000 CHANGE -------------- ---------------- --------- <S> <C> <C> <C> Pre-tax unrealized appreciation (depreciation) $11.4 $25.8 ($14.4) Deferred income tax (benefit) expense (4.5) (7.4) 2.9 -------------- ---------------- --------- After-tax unrealized appreciation (depreciation) $ 6.9 $18.4 ($11.5) ============== ================ ========= </TABLE> The decline in unrealized appreciation in the 2001 first quarter resulted from the sales described above, coupled with a decline in market prices in the insurance sector of the public equity markets and our high yield fixed maturity investments. INCOME TAXES Under current Bermuda law, ACGL is not obligated to pay any taxes in Bermuda based upon income or capital gains. We have received a written undertaking from the Minister of Finance in Bermuda under the Exempted Undertakings Tax Protection Act 1966 that, in the event that any legislation is enacted in Bermuda imposing any tax computed on profits, income, gain or appreciation on any capital asset, or any tax in the nature of estate duty or inheritance tax, such tax will not be applicable to us or our operations until March 28, 2016. This undertaking does not, however, prevent the imposition of taxes on any person ordinarily resident in Bermuda or any company in respect of its ownership of real property or leasehold interests in Bermuda. ACGL will be subject to U.S. federal income tax only to the extent that it derives U.S. source income that is subject to U.S. withholding tax or income that is effectively connected with the conduct of a trade or business within the United States and is not exempt from U.S. tax under an applicable income tax treaty with the United States. ACGL will be subject to a withholding tax on dividends from U.S. investments and interest from certain U.S. payors. ACGL does not consider itself to be engaged in a trade or business within the United States and, consequently, does not expect to be subject to direct U.S. income taxation. ACGL's U.S. subsidiaries will continue to be subject to U.S. income taxes on their worldwide income. 20
Upon our redomestication to Bermuda, Arch-U.S. distributed substantially all of its public equity portfolio to its Bermuda parent, ACGL, at the current market values and realized gains for tax purposes of $21,044,000. The associated income tax expense of $7,365,000 reduced Arch-U.S.'s net operating loss carryforwards by such amount. However, for financial reporting purposes, since the securities have not been sold to an unrelated third party, the realized gain has been deferred and was reported as unrealized appreciation in our consolidated financial statements. Accordingly, the income tax expense was also deferred and reduces unrealized appreciation in our consolidated financial statements. Income tax expense for the three months ended March 31, 2001 was $3.3 million, which included recognizing a portion of the deferred taxes described above relating to the investment gains realized during the period. This compares to income tax expense for the three months ended March 31, 2000 of $12.6 million, of which $6.3 million related to the establishment of a valuation allowance totaling $12.1 million against the deferred tax asset during that period. The remaining $5.8 million of the valuation allowance was included in the change in unrealized depreciation of investments. As of March 31, 2001, we have a deferred income tax asset valuation allowance of $7.8 million that adjusts our deferred income tax asset to its estimated realizable value of approximately $8.0 million. See note 10 under the caption "Income Taxes" of the notes accompanying our consolidated financial statements. CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS The Private Securities Litigation Reform Act of 1995 provides a "safe harbor" for forward-looking statements. This report or any other written or oral statements made by or on behalf of the Company may include forward-looking statements which reflect our current views with respect to future events and financial performance. All statements other than statements of historical fact included in this report are forward-looking statements. Forward-looking statements can generally be identified by the use of forward-looking terminology such as "may," "will," "expect," "intend," "estimate," "anticipate," "believe" or "continue" or their negative or variations or similar terminology. Forward-looking statements involve our current assessment of risks and uncertainties. Actual events and results may differ materially from those expressed or implied in these statements. Important factors that could cause actual events or results to differ materially from those indicated in such statements are discussed below and elsewhere in this report and include: o the availability of acquisition candidates and other investments on attractive terms; o competition for acquisition opportunities and in the businesses of the operating companies we have acquired or may acquire of form; o changes in the performance of the insurance sector of the public equity markets or market professionals' views as to such sector; o general economic conditions; o regulatory changes and conditions; o losses relating to aviation business and business produced by a certain managing underwriting agency for which we may be liable to the purchaser of our reinsurance business or to others; o our future business operations and strategy; o the integration of businesses we have acquired or may acquire into our existing operations; o rating agency policies and practices; 21
o greater than expected loss ratios on insurance written by our insurance subsidiaries and adverse development of claim and/or claim expense liabilities related to business written by our insurance subsidiaries in prior years; and o loss of key personnel. In addition to risks and uncertainties related to our business, our proposed acquisition of Altus Holdings, Ltd. is subject to various risks and uncertainties including, but not limited to, the risks that the conditions to closing will not be satisfied as well as risks relating to the successful integration of Altus' business. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. The foregoing review of important factors should not be construed as exhaustive and should be read in conjunction with other cautionary statements that are included herein or elsewhere. We undertake no obligation to publicly update or revise any forward-looking statement, whether as a result of new information, future events or otherwise. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Reference is made to the information appearing above under the subheading "Market Sensitive Instruments and Risk Management" under the caption "Management's Discussion and Analysis of Financial Condition and Results of Operations," which information is hereby incorporated by reference. 22
PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS The Company's insurance subsidiaries are involved in ordinary routine litigation and arbitration proceedings incidental to their insurance business. The Company does not believe that there are any material pending legal proceedings to which the Company or any of its subsidiaries is a party or of which any of their property is subject. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) EXHIBITS. Exhibit No. Description ----------- ----------- 10 Administrative Services Agreement, between Arch Capital Group Ltd. and Arch Capital Group (U.S.) Inc. 15 Accountants' Awareness Letter (regarding unaudited interim financial information) (b) REPORTS ON FORM 8-K. The Company filed a report on Form 8-K during the three month period ended March 31, 2001 on March 15, 2001 to report the closing of the Company's acquisition of American Independent Insurance Holding Company. The Company also filed a report on Form 8-K/A on May 14, 2001 to file required financial information relating to such acquisition. Omitted from this Part II are items which are inapplicable or to which the answer is negative for the period covered. 23
SIGNATURES ================================================================================ Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ARCH CAPITAL GROUP LTD. ------------------------------------ (REGISTRANT) /s/ Peter A. Appel ------------------------------------ Date: May 15, 2001 Peter A. Appel President & Chief Executive Officer /s/ Debra M. O'Connor ------------------------------------ Date: May 15, 2001 Debra M. O'Connor Senior Vice President, Controller & Treasurer 24
EXHIBIT INDEX Exhibit No. Description ----------- ----------- 10 Administrative Services Agreement, between Arch Capital Group Ltd. and Arch Capital Group (U.S.) Inc. 15 Accountants' Awareness Letter (regarding unaudited interim financial information)